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To Eliminate Income Tax Fraud, Simplify the Tax Code

By: Will Freeland

The New York Times, CNBC, and numerous other publications have reported that the IRS is paying out nearly $5 billion a year in fraudulent income tax refundA tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in a tax refund for millions. Overpaying taxes can be viewed as an interest-free loan to the government. On the other hand, approximately one-fifth of taxpayers underwithhold; this can occur if a person works multiple jobs and does not appropriately adjust their W-4 to account for additional income, or if spousal income is not appropriately accounted for on W-4s. s. Though the impulse may be to throw more money and more people at the problem, the solution is actually far easier: simplify the income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code.

Commentary by Syracuse University professor and tax policy expert Len Burman explains how the scam works:

The most common form of fraud simply requires criminals to obtain a valid name and social security number, preferably from someone who won’t be filing a tax return. Then the criminal makes up wage and withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. information, files a tax return electronically (avoiding the need for an actual W-2 form), claims a few deductions and tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s to produce a larger refund, and waits a couple of weeks for the refund.

Burman goes on to argue that the way to reduce this fraud is gathering and cross-checking more information. His solution involves spending more money for more IRS agents and upgraded data processes, in addition to higher compliance costs for business to report their employee’s income. Burman may lay out the most effective means of reducing fraud given the status quo of the income tax, but simplifying the code is a far superior means of reducing fraud.

After all, there is no particular reason that tax refunds must be a major part of an income tax for so many taxpayers. The main reasons refunds are currently necessary are tax overpayments and refundable tax creditA refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit. s.

Overpayments happen because no taxpayer really knows what their tax rate will be before filing a tax return. It’s only after filing a tax return that requires pages and pages of arithmetic in order to calculate exemptions, credits, and deductions that a taxpayer can figure out their true tax rate. With a simpler tax code, there would be no difference between an effective tax rate and the rate a taxpayer faces in their given income bracket. The federal government could withhold the exact amount of the tax burden, as long as a taxpayer didn’t have any major changes to income level or filling status. The rate you see on your withholding would be the rate you pay by the end of the year.

Refundable tax credits are one of the ways the federal government pays out social assistance to those who are employed. As with any government benefit program, there are people who attempt to abuse the system. IRS’s National Taxpayer Advocate found that tax code complexity is a contributing factor to the estimated $10 billion to $12 billion in fraudulent or erroneous overpayments made to those claiming the refundable earned income tax credit in 2006. Rather than invest in a costly system of fraud reduction, these social assistance payments could be administered with more oversight by the Social Security Administration or State public assistance offices—agencies that already have such fraud reduction systems in place.

The purpose of taxes should be to fund the necessary functions of government, not to incentivize behavior or pay out social assistance. A simpler tax code that focuses on this core purpose will reduce fraud, in addition to lowering compliance costs and removing economic inefficiencies.

See some of our past work on tax reform here, here, and here.

Follow me on Twitter @WilliamFreeland